"Welfare" - The Great Delusion

We have long argued that at its core, modern society, at least on a mathematical basis - the one which ultimately trumps hopium every single time - is fatally flawed due to the existence, and implementation, of the concept of modern "welfare" - an idea spawned by Otto von Bismarck in the 1870s, and since enveloped the globe in various forms of transfer payments which provide the illusion of a social safety net, dangles the carrot of pension, health, and retirement benefits, and in turn converts society into a collage of blank faces, calm as Hindu cows. Alas, the cows will promptly become enraged bulls once they realize that all that has been promised to them in exchange for their docility and complacency has... well... vaporized. It is at that point that the final comprehension would dawn, that instead of a Welfare State, it has been, as Bill Buckler terms it, a Hardship State all along. Below we present the latest views from the captain of The Privateer on what the insoluble dilemma of the welfare state is, and what the key problems that the status quo will face with its attempts at perpetuating this lie.

For the best part of the last two decades, it has been accepted as an indisputable fact even by the mainstream media that the two great pillars of the welfare state - medicare and social security - will break the government which offers them. Today, every nation in the world makes at least some pretense of providing “welfare” to its citizens. Since the “developed” (or “rich”) nations are those where these systems are most “developed”, these are the nations most at risk of crumbling under their burdens.

Welfare has many antonyms, but “hardship” is particularly apt in this context. Wikipedia’s entry on “welfare” ends like this: “... this term replaces “charity” as it was known for thousands of years, being the act of providing for those who temporarily or permanently could not provide for themselves.” As usual, the defining characteristic is missed. Charity is voluntary. “Welfare” as practised by government is compulsory. This makes the two terms opposites. It also brings about the opposite results. Charity is a voluntary act made by those who have a surplus to assist those who do not. “Welfare” is a system guaranteed to end up in hardship for everyone but particularly for those who are forced to be “charitable”.

The insoluble dilemma of a “welfare state” is twofold. First, it results in a situation in which the majority of people who vote are partially or wholly dependent on the state for their sustenance. In every “advanced” nation today, those who vote for a living outnumber those who work for one. It is true that not everybody, or even a majority of those eligible in many cases, bothers to vote at all. It is equally true that the “wards of the state” have much more incentive to vote than do those who are to provide for them.

The second dilemma is the issue of the unfunded liabilities. The US government divides its budget into discretionary and NON discretionary items. The bulwarks of the welfare state, social security and medicare, fall into the second category. They are considered untouchable. There are only two problems here. First, the unfunded liabilities of these two programs are somewhere in the order of $US 80 - 120 TRILLION. Second, any talk of sharply lower annual deficits (let alone talk of a return to a budget balance) are puerile without MAJOR surgery being performed on medicare and social security. They are gigantic millstones around the neck of the US economy as they are on the economies of all other nations.

In the hands of government - “welfare” becomes its antithesis - “hardship”. Today, this is being illustrated in real time in Greece. But no nation can afford a welfare state in the long run.

It appears that the "Captain" is on to something here. A few short hours ago none other than Goldman Sachs was forced to come out with a report attempting to justify this most fundamental social illusion, in "Is Health Spending Unsustainable" - that only Goldman, and potentially the San Fran Fed, could put this question for serious debate when it is well known that the unfunded liabilities associated with such luxuries is in the triple trillion digit ballpark, speaks volumes. Yet, since even Goldman is now floating various "trial balloons", we can only assume that this is about to become a big issue for policy, especially ahead of the Supreme Court's hearings later this month on the constitutionality of the national health care law.

From Goldman Sachs

I. Is Health Spending Unsustainable?

Health spending in the US exceeds that of any other developed nation, topping the next largest spender by nearly half again as much (as a share of GDP). Spending has also tended to grow faster in the United States than elsewhere (Exhibit 1). Unchecked spending runs the risk of destabilizing public finances, reducing competitiveness with trading partners, and ultimately crowding out other productive uses of resources. This is particularly the case if health spending is inefficient (Exhibit 2).

However, the case that health spending is “unsustainable” isn’t as clear cut as the debate has sometimes made it out to be. After all, dedicating a larger share of future income gains to improving health could be a more productive investment than increasing other forms of personal consumption. Moreover, while health spending within federal programs is clearly unsustainable under current policies and growth trends, whether broader health spending should also be deemed to be growing too quickly depends on whether increased spending improves outcomes and whether it affects the ability of the rest of the economy to grow.

What Drives Health Spending?

From 1970 through 2010, nominal health spending grew at an average annual rate of 9.7%, well in excess of nominal GDP growth of 6.8%. Excess growth was greatest in the 1970s and 1980s, declined in the 1990s, and reaccelerated somewhat in the last decade (Exhibit 3). Continual growth in excess of GDP growth has led health spending to reach 15% of GDP (Exhibit 4). Notably, this has occurred while the out of pocket costs to patients and consumers have declined, replaced by indirect costs such as insurance premiums and taxes that fund public programs, as well as federal borrowing.

There is no single cause for excess growth in health spending, but a large body of research has focused on the drivers of growth and has reached qualitatively similar conclusions, as shown in Exhibit 5:

Technology. Advancement in the state of technology typically increases cost over existing products or procedures, though it may produce savings in other areas. Academic work has typically attributed residual spending growth to technology, after accounting for other measurable factors. More recent work has tended to find a slightly smaller though still large contribution from technology to total health spending.The exact magnitude is necessarily imprecise in any case, given substantial interaction between the availability of new technology and willingness to pay for it due to rising incomes and greater insurance.

Income. Differences in income explain a good deal of international variation in the health spending to GDP ratio (Exhibit 6). This implies that as societies become richer, they devote a greater share of additional income gains to health rather than other forms of consumption. We find that regressing excess cost growth through 2010 against real GDP growth with a one year lag produces a statistically significant coefficient similar to the estimates shown in Exhibit 5.

Insurance. The RAND Health Insurance Experiment conducted in the late 1970s found an insurance elasticity of 0.2, which implies that around 10% of the increase in real per capita spending growth since 1960 is attributable to increased insurance coverage. A more recent study examining the effect of coverage in Medicare found a much greater effect, suggesting increased insurance coverage could be responsible for as much as half of the increase in per capita spending. (See Amy Finkelstein, “The Aggregate Effects of Health Insurance: Evidence from the Introduction of Medicare,” 2006.)

Demographics. The contribution of aging of the population to spending growth is more certain but even here there are differences in estimated magnitude. Clearly, aging will become a more important source of health spending growth over the next two decades, but as spending on the “baby boomer” generation peaks, income growth and technology are likely to be more important factors over the long run.

What do official projections assume?

Despite chronic health spending growth in excess of GDP growth (an average of 2.1 percentage points on a real per capita basis since 1975) official estimates of Medicare solvency had until about ten years ago assumed a long-range growth rate essentially equivalent to GDP. This was eventually increased to GDP plus one percentage point, where it remained until passage of the Affordable Care Act (ACA). Following enactment of that law, the official Medicare projections reported annually by program trustees are now based on growth of GDP minus 0.1 percent.

The ACA permanently reduced annual payment increases for Medicare providers and sets in motion a number of payment policy reforms that could lower utilization, so a reduction in future Medicare cost growth of this magnitude seems reasonable. However, these new lower projections have upside risk given that some of the reduction in growth stems from sizeable payment reductions that might eventually be reversed. Moreover, while the ACA improved Medicare finances, these savings as well as new taxes go to finance insurance expansion, which will raise total health spending in the medium term (Exhibit 7).

When Does Health Spending Become Unsustainable?

One of the difficulties in determining how long health spending is likely to grow as a share of the economy is that the US health care system has not existed for all that long in its current form. Commercial insurance companies only began to offer health insurance on a large scale around World War II (partly due to the employer response to wage controls), and federal health insurance programs (Medicare and Medicaid)were not established until the 1960’s. That said, some trends would likely prompt a reduction in health spending growth:

Public finances become strained. Since health spending totals about 15% of GDP but 23% of federal outlays, when health spending grows in excess of GDP, government spending as a share of GDP will necessarily expand. The demographic mix of publicly vs. privately insured individuals will add to fiscal pressures. Exhibit 8 shows the trajectory of spending assuming that historical excess cost growth gradually slows to zero and that certain cost containment policies are not maintained over the long term.

Whereas the private sector can gradually respond to increased health spending, the public sector—and particularly the federal—reaction is apt to be much slower, leading to deficit spending until changes are adopted. As shown in Exhibit 8, health spending if left unchecked would not only crowd out other spending but would also eventually exhaust all federal revenues.

Of course, we would expect the situation to be addressed long before this happens.

Health spending begins to crowd out real non-health consumption. This is not such a hard test to meet over the medium term, mainly because of the “low” base from which health spending as a share of GDP starts. Real per capita spending growth of around GDP+1.5% would slow but probably not reverse nonhealth consumption growth over the next 75 years, though this depends greatly on real growth and demographic assumptions (Exhibit 9).

Increased health spending begins to weigh on growth, creating a vicious circle. This appears quite distant, if it ever occurs. The main concern here would be that rising health spending crowds out other productive activities (for instance, fixed investment or education), reducing potential output and further increasing relative health spending. Alternatively, higher taxes (to pay for public programs) or insurance premiums (to pay for private insurance) would reduce workers’ take-home pay, with potentially adverse incentive effects at a certain level.

Finally, there is some evidence from businesses that excess health costs reduce employment and output. (Sood et al, find that a 10% increase in excess cost growth (i.e., about 20bps) leads to 121,000 fewer more jobs and $14bn in lost value added. See Neeraj Sood, Arkadipta Ghosh and Jose Escarce (2009) “Health Care Cost Growth, Employer Provided Insurance and the Economic Performance of U.S. Industries,” Health Services Research, Vol 44.)

When the Time Finally Comes…

If costs are ultimately deemed too great (or projected growth too fast) what can be done? The decision before policymakers, employers, and individuals falls along two lines: first, what share of total output should be devoted to health care instead of other goods and services, and second, what is the optimal mix of public vs. private payment for whatever share is decided. This leaves three options:

1. Limit growth in health care costs regardless of payor, because activities that would otherwise be crowded out by health spending are deemed more important. Reaction to rapid growth in the 1980s— health spending consumed around 25% of overall per capita real income growth—led to Medicare payment reductions and broader use of managed care. This, along with strong growth elsewhere in the economy,stabilized the health share of GDP temporarily. Future restraint in health spending is likely to come from elsewhere, particularly given that Medicare cuts were already used to finance new spending under the ACA, so those savings have already been captured. A reduction in the geographic disparity of health spending is one option for future savings—patients in some areas of the country receive much greater intensity of treatment at greater cost than patients in other parts of the country, but show little medical benefit. (See for instance “Health Care Spending, Quality, and Outcomes; More Isn’t Always Better,” Dartmouth Institute for Health Policy and Clinical Practice, 2009) Use of information technology to increase medical and administrative efficiency is another.

2. Allow health spending to rise, but reallocate payment responsibility from the public sector to the private sector, in order to avoid the fiscal consequences that would follow, i.e., tax increases or spending cuts elsewhere in the budget. Since most of the public policy discussion regarding the rise in health spending relates to Medicare, and to a lesser extent Medicaid, it is quite possible that policymakers will find it sufficient to shift the financing burden for health costs away from the federal budget. This could mean an increase in the burden on state governments (they already face growth in Medicaid spending under the ACA), and would almost certainly imply increased cost-sharing for Medicare enrollees, thus shifting some of financing burden back to the private sector in the form of higher out of pocket spending. Under some proposals, such as that offered by House Budget Committee Paul Ryan, Medicare spending would be capped at GDP+1. The Bowles-Simpson proposal would apply the limitation more broadly, limiting federal health spending and the tax exclusion for employer sponsored benefits to GDP+1, though it is not specific on how this would be accomplished.

3. Allow public health spending to rise and reallocate resources to pay for it. While it is unlikely that public-sector health spending growth would go completely unchecked, it is possible that additional health spending restraint could be modest, with a greater focus on reallocating resources to cover increasing state and federal health costs. The result would likely be higher taxes in this scenario, since in 2011 Congress already capped discretionary spending (annual appropriations by Congress) and automatic cuts set to take effect next year would reduce this segment further (we assume these will be pushed back past 2013). We estimate that the primary budget deficit (i.e., excluding interest) will average around 2% of GDP over the next ten years and it is politically unrealistic to imagine that such a large amount of savings can be found in the 13% of the budget that excludes appropriations, health, and Social Security. The upshot under this scenario would most likely be a tax increase of a magnitude similar to our estimated primary deficit of around 2% of GDP (roughly the size of the 2001/2003 tax cuts set to expire at year end). However, this would be the minimum under such a scenario, for two reasons: first, health spending would continue to rise, requiring additional tax hikes later on. Second, eliminating the primary deficit over the medium term is the minimum—a primary surplus is needed to bring down the ratio of debt to GDP.

The ultimate outcome is likely to be a combination of all three scenarios, though we suspect public policy will focus on the second and third options since they have less ability to influence the growth of privately financed health spending. It is also worth noting that health spending may naturally slow as its ratio to GDP rises; a simple regression of excess cost growth against the lagged ratio of health spending to GDP shows a coefficient of around -0.25, implying a gradual slowing in the growth rate even as the level of health spending continues to increase.